3 annuity mistakes to avoid

What not to do when evaluating annuities for retirement

If you’re comparing annuities to other investment products, you’re making a classic mistake—and it’s just one of three major errors that consumers and financial experts make when evaluating annuities, according to a panel of experts at a recent MarketWatch Retirement Adviser event in New York that focused on income strategies.

“Both immediate and deferred annuities have been shown to have a very positive role in an overall retirement-income strategy, but the deployment of these instruments is often hampered by some very fundamental misunderstandings,” said John Olsen, president of Olsen Financial Group, and author of a number of books on annuities, including “Index Annuities: A Suitable Approach.”

The panel, moderated by MarketWatch senior columnist Robert Powell, also featured Farrell Dolan, principal with Farrell Dolan Associates, and David Blanchett, head of retirement research at Morningstar Investment Management.

Mistake No. 1: Unfair comparisons

One such misunderstanding—and it’s often made by financial experts, Olsen said—is to assess the value of a variable deferred annuity as though all of its costs “are nothing but pure overhead.” That can lead consumers to view such annuities as unreasonably expensive.

Instead, he said, those costs “are charges for the transfer of risk from the shoulders of the buyer to the insurance company.”

Consumers need to remember, Olsen said, that “any insurance product on the planet will not pay off on average. If the average buyer of any insurance product profits from purchasing it, the insurance company will go broke. That’s something we need to recognize when we analyze risk-management strategies.”

Olsen was quick to point out that insurance costs shouldn’t be ignored. They might be too high or too low. But insurance shouldn’t be compared to other products.

“When you compare, as some bad analysts do, a non-qualified mutual fund that has no such insurance benefits with a deferred variable annuity that does, and then say, ‘Well see, this is more expensive.’ Why not compare apples with oranges? Fundamentally, it’s a misconception,” Olsen said.

MarketWatch’s Powell noted that one reason people misunderstand annuities is that financial experts and the media have focused on saving for retirement and, to a large extent, investment returns and “return management,” rather than risk management and, specifically, the risk of outliving one’s assets.

“We’ve been telling people to save for retirement, but not really told them how to convert assets to income,” Powell said. “People have to get their arms around this different way of looking at retirement. No one ever had to think about outliving their assets years ago.”

The reason to buy an annuity is because you “want the absolute insurance of having that income in your checking account every month,” Olsen said. “Saying, ‘I don’t like the return on investment’ or the internal rate of return misses the whole point. Annuities aren’t about internal rate of return. They’re about the absolute assurance of an income that you cannot outlive.”

Plus, don’t forget about the value of “mortality credits,” said Dolan, of Farrell Dolan Associates.

Mortality credits are a form of risk pooling, he said, a mechanism through which premiums paid by investors who die earlier than expected provide a higher yield to investors who live longer. “If a couple hundred thousand people get together and put money into a pot, some will die early, some will die later; those that die early fund those that live longer,” Dolan said, noting that Social Security is based on the same idea.

Annuities are a means by which retirees can maximize mortality credits, he said. “When mortality credits really start to have a higher impact [is] around age 70,” he said. Even at today’s interest rates, “the cash flow that comes out is around 7%. If you wait longer, it might be 7.5%. And by cash flow, I mean if you put in $100,000, you’ll get $7,000 back guaranteed every year,” he said.

“That’s not a bad cash flow, but it requires the mind to think cash flow, not return on investment,” Dolan said.

Dolan added that at his current age of 64, he doesn’t have mortality credits, but in 10 years, when he does, he will adjust his portfolio. Currently his portfolio is focused on flexibility and growth; in 10 years, he said, he’ll focus on “pulling more guarantees into my portfolio. And that’s exactly when this mortality credit thing tends to work, because it’s age-based.”

Others agreed. “Interest rates being low won’t affect the payout of an annuity when someone is 85 years old, because all that matters is the life expectancy at that point,” said Morningstar’s Blanchett.

Also, Blanchett said, “For someone who is about to retire, if you don’t like today’s annuitization rates, delay your retirement for Social Security. That is a phenomenal payout,” he said, noting that those who delay from their full retirement age to age 70 enjoy what amounts to an 8% guaranteed rate of return each year, increased for inflation.

“If you have the assets to create income from age 62 to 70…delay it as long as possible,” Blanchett said. “There’s the guaranteed benefit, and then your spouse receives the greater of your two benefits, so there’s significant value added for people delaying Social Security.”

Mistake No. 3: Failing to annuitize

Perhaps the biggest mistake is simply failing to annuitize assets to create a guaranteed stream of retirement income.

“We have really good evidence that annuitization of part of a portfolio can significantly reduce the failure rate of that portfolio to produce required income over a required period of years, which may be a lifetime,” Olsen said. ”But people don’t do it.”

For his part, Morningstar’s Blanchett said that a focus on historical returns may make annuities seem like a bad deal. But that may change going forward, he said.

“We have this kind of perception, using past data, that it’s very easy to create a lot of income for a long time period,” Blanchett said. “If you just use some historical data, you can get a very negative perspective on annuities. You might say that you don’t need them. I think that the last decade has shown us, though, that it’s tough to take money from a portfolio and have that portfolio survive for a long time.”

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